The Judiciary and Investor Protection

The Rule 10b-5 action is a judicially implied private right of action designed to remedy the shortcomings of common-law fraud. The Supreme Court has, however, constructed many positive elements that serve as obstacles to investor recovery.

Material Misstatements and OmissionsIn Connection with the Purchase or Sale of a SecurityAlleging the Defendant’s Culpable Mental State: ScienterEstablishing Reliance on a Classwide Basis: The Fraud-on-the-Market TheoryLoss CausationThe Scope of Liability: Primary Violators, Aiders and Abettors, and Scheme LiabilityInsider TradingThe Extraterritorial Application of Rule 10b-5Damages, Rescissory Remedies, and ContributionDuplicative Remedies Under the Securities Laws The Statute of LimitationsArbitration of Securities Law Claims

MATERIAL MISSTATEMENTS AND OMISSIONS

For fraud to be actionable it must be a material misstatement or omission. In TSC Industries Inc. v. Northway, the Supreme Court interpreted material to mean that a fact is material if a reasonable investor would have considered it significant in making the investment decision. Whether something is material depends on an assessment of all relevant circumstances to the particular case. As such, the Supreme Court has repeatedly rejected attempts to craft bright-line rules to determine materiality. In Basic Inc. v. Levinson, the Court rejected a bright-line that merger negotiations do not become material until there is an agreement in principle. In Matrixx Initiatives Inc. v. Siracusano, the Court rejected a bright-line rule that adverse event reports about a pharmaceutical company’s products do not become material until the reports are statistically significant.

For the full text of the Supreme Court’s decisions discussing material misstatements and omissions, follow the links below:

Fraud must be “in connection with the purchase or sale” of a security. The Supreme Court in Superintendent v. Bankers Life, recognized, however, that the “in connection with” requirement does not mean that the fraud must relate to the terms of the transaction. And in SEC v. Zandford, the Court recognized that the fraud does not even have to be in connection with a particular securities transaction. Rather, there must only be some nexus between the fraud and the purchase or sale of the security. The 10b-5 private right of action is not unlimited, however. In Blue Chip Stamps v. Manor Drug Stores, the Supreme Court held that only purchasers or sellers of securities in the transaction being attacked may bring a private cause of action under Rule 10b-5.

For the full text of the Supreme Court’s decision discussing when fraud is in connection with the purchase or sale of a security, follow the links below.

The Supreme Court in Ernst & Ernst v. Hochfelder, held that Section 10(b) and Rule 10b-5 as antifraud measures require plaintiffs to allege and prove that the defendant acted with a culpable state of mind, which the securities laws term “scienter.” The Court in Santa Fe Industries, Inc. v. Green, then clarified that Section 10(b) and Rule 10b-5 do not extend to breaches of fiduciary duty or corporate mismanagement. Rather, scienter includes an intent to deceive, manipulate, or defraud. The federal courts have recognized that “intent” includes some degree of recklessness as well.

The PSLRA codified the scienter requirement and also required plaintiffs to allege a “strong inference” of scienter. 15 U.S.C. § 78u-4(b)(1)-(2). In Tellabs, Inc. v. Makor Issues & Rights Ltd., the Court established a three-step process district courts must undertake when assessing whether a plaintiff has alleged a “strong inference” of scienter. First, when faced with a motion to dismiss a Section 10(b) action, the court must accept all factual allegations in the complaint as true. Second, the court must examine the complaint in its entirety, and ask whether as a whole, the facts give rise to a “strong inference” of scienter. Third, the court must compare the culpable and nonculpable explanations and find that the culpable inference is at least as likely as the non-culpable explanation to ensure that the inference of scienter is strong.

For the full text of the Supreme Court’s decisions discussing scienter, follow the links below:

The Supreme Court has repeatedly recognized that reliance is an essential element of liability under Rule 10b-5. According to the Court, reliance supplies the requisite causal connection between a defendant's deceptive act and the plaintiff's injury. But the Court has also recognized that the class action mechanism is vital to injured investors.

When someone makes a false (or true) statement that adds to the supply of available information, that news passes to each investor through the price of the stock. And since all stock trades at the same price at any one time, every investor effectively possesses the same supply of information. The price both transmits the information and causes the loss. This approach, dubbed the fraud-on-the-market doctrine, supplants “reliance” as an independent element by establishing a more direct method of causation.Schleicher v. Wendt, 618 F.3d 679 (7th Cir. 2010).

Without the class action, investors may suffer losses that make individual lawsuits impracticable. Thus, the Court has interpreted substantive elements of the 10b-5 private right of action to facilitate classwide resolution. Most notably, the Court has adopted presumptions of reliance that largely abrogate this element. In Affiliated Ute Citizens of Utah v. United States, the Supreme Court recognized that a court should presume reliance if a defendant does not disclose material facts where the defendant is under a duty to disclose. In other words, in the case of fraudulent omissions, courts will presume reliance. Second, in Basic, Inc. v. Levinson, the Court held that where stock is traded on an open and efficient market, the court will presume reliance because the fraud, according to the Court, is impounded in the stock price. This is the fraud-on-the-market theory, and it entitles plaintiffs to a rebuttable presumption of reliance. The Court in Erica P. John Fund, Inc. v. Halliburton reaffirmed the fraud-on-the-market theory and held that plaintiffs are entitled to this rebuttable presumption once they show that the stock traded on an efficient market and plaintiffs do not have to show loss causation as a precondition.

Plaintiffs must also allege and prove that the defendant's fraud caused their actual economic losses. The PSLRA codifies this requirement. See 15 U.S.C. § 78u-4(b)(4). Loss causation has proved to be controversial and a considerable barrier for plaintiffs. In Dura Pharmaceuticals Inc. v. Broudo, the Court held that plaintiffs could not allege or establish loss causation merely from evidence that the plaintiff bought securities at an artificially inflated price. Rather, loss causation requires plaintiffs to allege that the stock price was inflated by fraud and that this inflation was later dissipated in such a way that the plaintiff could not recover it.

For the full text of the Supreme Court’s Dura decision, follow the link below:

THE SCOPE OF LIABILITY: PRIMARY VIOLATORS, AIDERS AND ABETTORS, AND SCHEME LIABILITY

The Supreme Court has cabined the scope of persons potentially liable under Rule 10b-5. In Central Bank of Denver v. First Interstate Bank, the Court held that plaintiffs could not maintain a 10b-5 suit for aiding and abetting securities fraud. Rather, defendants had to be primary violators. In Janus Capital Group, Inc. v. First Derivative Traders, the Court further limited the scope of who is a primary violator. In Janus, the Court held that only those who control the content and dissemination of a fraudulent statement can be primary violators under the securities laws.

Insider trading is the purchase or sale of securities in connection with a failure to disclose material nonpublic information. Generally, insider trading, whether it involves tippers or tippees, reduces to whether the defendant made an omission that was rendered material because it breached a fiduciary duty. The Supreme Court in Chiarella v. United States, explained than an insider has a duty to disclose or refrain from disclosure when (1) the existence of the relationship affords access to inside information intended only for corporate purposes; and (2) it would be unfair to allow the insider to benefit from this access. In Dirks v. SEC, the Court held that a defendant breaches a fiduciary duty not to profit from material nonpublic information when the defendant knows or should know that the information was received fro, and a benefit was paid to, a person whose disclosure itself was a breach of a fiduciary duty. In United States v. O’Hagan, the Court held that a defendant breaches a fiduciary duty running to the source of information by misappropriating the information entrusted to the defendant and capitalizing on the breach by trading on that information.

The Supreme Court in Morrison v. National Australia Bank, Ltd., held that Section 10(b) and Rule 10b-5 only apply to (1) purchases or sales made in the United States; or (2) transactions involving a security listed on a domestic exchange. This holding has dramatically curbed the extraterritorial application of Rule 10b-5.

The Supreme Court announced in Affiliated Ute Citizens of Utah v. United States, that the primary measure of damages in a securities fraud action is the plaintiff’s “out of pocket” losses. That measure of damages is calculated by the actual difference between the price at which the plaintiff actually invested and the price at which the plaintiff would have invested had the truth been known at the time of the transaction. Additionally, inRandall v. Loftsgaarden, the Court held that rescissory remedies are sometimes available to litigants under Section 10(b) and Rule 10b-5. A rescissory remedy allows a plaintiff to recover the consideration paid for the security with interest, less the amount of any income received, upon the tender of the security.

For the full text of the Supreme Court’s decisions that discuss the proper measure of damages and rescission, follow the links below:

Fraud under Section 10(b) and Rule 10b-5 may also violate other prohibitions contained in the securities laws. Nevertheless, the Supreme Court has recognized that plaintiffs can pursue duplicative remedies under the securities laws. In Herman & MacLean v. Huddleston, the Court held that a purchaser could sue under Rule 10b-5 for misstatements in a registration statement while pursuing a claim under Section 11 of the Securities Act of 1933. For the full text of the Supreme Court’s decisions that discuss duplicative remedies under the securities laws, follow the links below:

Originally, the 10b-5 private right of action did not contain a statute of limitations because it was judicially created. Federal courts often borrowed statutes of limitations contained in other provisions of the 1934 Act to supply a limitations period for the 10b-5 action. Eventually, the Supreme Court settled the statute-of-limitations question in Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, and adopted a one-year statute of limitations and a three-year statute of repose.

In 2001 the landscape of corporate regulation changed when massive corporate scandals rocked investor confidence in American markets. Congress responded with the Sarbanes-Oxley Act of 2002 (“SOX”), which, among other things, expanded the statute of limitations applicable to most private remedies under the securities laws. For Section 10(b) and Rule 10b-5 claims, SOX now provided a two-year statute of limitations and a five-year statute of repose. 28 U.S.C. § 1658(b). In Merck & Co. v. Reynolds, the Court held that the two-year statute of limitations for plaintiffs begins, not when they actually discovered the fraud, but when they discovered or should have discovered the facts constituting securities fraud, which includes scienter.

For the full text of the Supreme Court’s decisions pertaining to the statute of limitations and the statute of repose, follow the links below:

The Supreme Court in Shearson/American Express v. McMahon, held that account forms signed by customers that require those customers to arbitrate disputes were enforceable arbitration agreements. The practical effect of this holding is that brokerage firms now require customers to sign these documents, requiring binding arbitration.